Tyler Cowen recently linked to a George M. Constantinides study of the welfare costs of unstable consumption:
I estimate welfare benefits of eliminating idiosyncratic consumption shocks unrelated to the business cycle as 47.3% of household utility and benefits of eliminating idiosyncratic shocks related to the business cycle as 3.4% of utility. Estimates of the former substantially exceed earlier ones because I distinguish between idiosyncratic shocks related/unrelated to the business cycle, estimate the negative skewness of shocks, target moments of idiosyncratic shocks from household-level CEX data, and target market moments. Benefits of eliminating aggregate shocks are 7.7% of utility. Policy should focus on insuring idiosyncratic shocks unrelated to the business cycle, such as the death of a household’s prime wage earner and job layoffs not necessarily related to recessions.
That seems plausible to me. So why do I focus on the business cycle?
Although business cycles have a smaller impact on welfare, they are also much easier to address with public policy. There are nearly costless solutions for reducing the welfare costs of business cycles, such as NGDP level targeting. In contrast, we don’t have anywhere near as much knowledge about the best way to reduce idiosyncratic consumption volatility. To be sure, there are programs that try to do this, such as unemployment insurance. But it’s really hard for the government to design programs that are cost effective. That doesn’t mean that we shouldn’t try, just that the solutions are not obvious.
I’m attracted to business cycle research because it seems like a low hanging fruit. Maybe not the biggest fruit on the tree, but the easiest one to pluck with one hand.
READER COMMENTS
Mark Z
Jul 16 2021 at 5:43pm
There are also readily available ways to insure against idiosyncratic shocks, such as life insurance or unemployment insurance, whereas I don’t think insurance companies offer business cycle insurance. That many people don’t insure against such things may just reflect that they’re risk tolerant enough to not think it’s worth it.
BC
Jul 17 2021 at 4:38am
Yes, exactly. Idiosyncratic shocks are easy to insure because, by definition, they are uncorrelated across individuals. Given the purported welfare gains, policy should probably be directed towards removing regulatory and other barriers to competition, if any, so that idiosyncratic risks can be efficiently diversified away. (It’s also possible that adverse selection could be a problem in life insurance markets. I have no idea.)
One can buy “insurance” against systemic (business cycle) shocks too — out-of-the-money puts on broad market indexes, for example — but such insurance carries substantial risk premiums because the risks are not diversifiable. So, systemic risk is not diversified away by insurance pooling. Rather, systemic risk is merely transferred between parties. Policy that reduces business cycles can reduce the overall systemic risk that must otherwise be borne by someone.
Ben Polidore
Jul 17 2021 at 9:58am
Also, if you think of “welfare” as a portfolio, you really want to get rid of the correlated risks that can lead to ruin. The business cycle is a correlated shock that affects all “assets” (people). Most portfolios just take exposure to idiosyncratic risk as a cost of doing business and focus hedging expense on correlated macro factors. Extending this metaphor, to hedge all assets against idiosyncratic risk, you’d have to buy puts (insurance) on every single one, which is expensive and usually not done!
Scott Sumner
Jul 17 2021 at 2:10pm
I should have mentioned that consumption risk is not the only problem created by business cycles. There is also unemployment, which probably lowers the average level of consumption.
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